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The BEPS Project Lacks Comprehensive Definition on the

Taxation of Digital Economy in Market Jurisdictions
By Guillermo O.
Teijeiro

The BEPS Project Lacks Comprehensive Definition on the Taxation of Digital Economy in Market Jurisdictions

An open door for emerging economies or the beginning of the end in international tax co-ordination

In an article published earlier this year, I alerted on the instability of the current world tax scenario, based on a
number of different but confluent circumstances including, inter alia, potential inter-country tax imbalances that
might originate in the perceived desire of governments (from industrial and emerging economies as well) to grasp
income from borderless activities — such as the various manifestations on the digital economy — whether at
residence or at the place of destination (i.e., the customers’ jurisdictions).

I also observed that should the BEPS Project failed at the end to impose uniform principles on the taxation of the
digital economy, chances were certain that countries would attempt to stretch source rules and business presence
tests beyond the application of the traditional PE concept, or even depart completely from it to try alternative paths
for taxation such as formulary apportionment or destination-based corporate tax, just to mention a couple of them.

Following the release of the final BEPS package earlier this month, and based on the content of the Final Report
on Action 1 (Addressing the Tax Challenges of the digital Economy) and remaining correspondent actions (e.g.,
Action 7), the fears of unilateral country responses that might lead to a tax jungle in the digital economy area
deepen. And this is so because BEPS final outcomes in this area and accompanying actions are just halfway
patches that appear not to fulfill expectations, particularly in market jurisdictions.

Insofar as Action 1 is concerned, the discussion draft issued last year had fell short to the Action’s goals, and the
final document, instead of stepping forward with a OECD-G20 shared comprehensive recommendations, simply
recognized that absent that response, countries may wish to go further individually, adopting a substantial
economic presence test or digital PE concept, a withholding on digital economy’s yields (such as the UK Diverted
Profit Tax), or an equalization levy. If these initiatives (or other available alternatives such as formulary
apportionment or destination-based corporate tax) were to become widespread on an unilateral basis, it is not
difficult to foresee a digital economy tax world where countries’ incoordination, jurisdictional overlaps, and,
possibly, cascade taxation, might become rampant.

Someone may argue that the discussion of source rules, the definition of a new nexus to attribute the income
yields from digital economy manifestations, and related income characterization issues are indeed issues which
are beyond the objectives of the OECD-BEPS Action Plan, but that it is not certainly the case.

Having said that, let’s turn to the concluding recommendations arrived at by the Tax force on the Digital Economy
(TFDE) on the BEPS issues and the broader tax challenges raised by the digital economy:

(1) In the PE area, and in conjunction with the outcome of Action 7, it is agreed to amend the negative list
(activities excluded) of Article 5, paragraph 4, OECD MC, to ensure that the exceptions contemplated therein are
solely effective where the activities are of a preparatory or auxiliary character; and to introduce a new anti-
fragmentations guide to ensure that it is not possible to benefit from the exceptions through the fragmentation of
business activities among closely related enterprises;
(2) It was also agreed to amend the PE definition to address circumstances in which artificial arrangements
relating to the sale of goods or services of one company in a MNE group effectively result in the conclusion of
contracts, in which case the sales would be treated as if had been made by that company having a PE in the
market jurisdiction;
(3) Recommendations on the design of CFC rules include definitions of CFC income that would subject income
that is typically earned in the digital economy to taxation in the jurisdiction of the parent company.

Bearing in mind that the basic directives on e-commerce in the Commentaries to Article 5, paragraph 7,
subparagraphs 42.1 to 42.10 have remained unchanged since 2003 and are thus outdated, it appears that the
changes mentioned in 1 and 2 above will have little, if any, impact in enlarging the market countries’ jurisdiction on
today digital economy manifestations. In effect, that will happen only in isolated instances, e.g., when physical
goods are traded and need to be kept for delivery in the market jurisdictions, or when related services (e.g.,
guarantee services) need to be provided, and are entrusted to another company within a MNE group through an
artificial fragmentation of the business aimed at avoiding PE status in the market jurisdiction.

On the contrary, inclusion of income items earned in the digital economy in CFC income (royalties, IP income,
income from sales and services; and, at the minimum, funding returns allocated under transfer pricing rules to low-
function cash boxes) appears to lead to a recommended all-embracing domestic rule tipping the balance in favor
of residence jurisdictions, thus somehow making the area of digital economy taxation an exception to the
otherwise perceived shift towards more source based taxation under BEPS’ outcomes generally.

Chapter 7 of the Final Report on Action 1 deals with the broaden direct tax challenges raised by the digital
economy and the options to address them, including a discussion of those not agreed upon and, hence, not
recommended by TFDE. The options are: (i) a new nexus based on the concept of significant economic presence;
(ii) a withholding tax on digital transactions; and (iii) an equalization levy.

These options are presented without expressing any preferences and thus, without a clear guide on their concrete
application by countries concerned; moreover, their main features are foremost meagerly described, so that
potential application at the national level may show great variances.

The significant economic presence test would create a taxable presence at the market jurisdiction on the basis of
factors that evidence a purposeful and sustained interaction with the economy of that country via technology and
other automated tools, such as a local domain name and a local Website or digital platform, availability of a local
payment option; or even user-based factors, including monthly active users (MAU) in the country, the regular
conclusion of on-line contracts with resident users, and the volume of digital content collected from resident users
and customers. It is recommended that digital and user-based factors (to be chosen in accordance with the
features and characteristics of the particular market) be also combined with a revenue factor, i.e., revenues
obtained from remote transactions into the country in excess of a revenue threshold, in order to ensure that only
cases of significant economic presence are covered.

The question is why a source, emerging economy, would need to resort to a significant economic presence test in
its domestic laws to tax digital economy’s income yields and the response in rather simple (i) direct taxation of
foreign automated internet sales and services might be deemed to lack sufficient nexus with the taxing jurisdiction,
(i) the market jurisdiction may consider income from foreign sales of tangible goods and/or foreign services into
the country to be foreign source income, in which case unless a significant presence test is introduced, taxation of
remote online similar sales and services would be incoherent with the treatment afforded to traditional inbound
sale and service income; and (ii) because net-basis taxation of digital economy income might be deemed
preferable.

A second option to be considered is a standalone gross-basis final withholding tax on digital transactions, i.e.,
payments to nonresident providers of goods and services ordered online (digital sales transactions), under certain
specific conditions. In this case the definition of the transaction covered as well as of the definition of the local
collecting agent [e.g., the customer (for B2B or B2G transactions) or a third-party payment processing
intermediary (for B2C transactions)] are crucial design element to be considered.

The UK option of designing the withholding as a levy applied separately from the income tax might also help
bypassing tax neutrality challenges coming from the fact that income tax rules would still treat income from
inbound traditional sales and services as foreign source, if and when that is the case under the market
jurisdiction’s legislation. Of course that would not be a problem is income from traditional inbound sales and
services were deemed domestic source income and, hence, taxed at destination.

The third and apparently simpler alternative discussed by TFDE is the creation of an equalization levy, for
example under the form of an excise tax applied if and when it is determined the existence of a significant
economic presence, or on all remote sales transactions entered into with customers in a market jurisdiction.

A common issue to withholding taxes designed as separate levies and equalization levies would be the crediting
against the corporate income tax payable at home. One possible way out of this concern could be to limit taxation
at the market jurisdiction under any of these forms to the case of income that would otherwise be untaxed at
home, or allowing a special credit at home, something that looks at least troublesome.

The door appears to be open for emerging economies to grasp income from digital economy activities but different
responses in terms of available tools might stretch jurisdictional principles beyond an acceptable reach, as well as
catastrophically affects cross-border remote trades. Further guidance on the matter would have been welcome.

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